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Stock picking, and not timing, creates wealth

To create wealth consistently over the long run, a company has to offer a unique product or service

Investing in equity is not so much about knowing market peaks and troughs, rather it is about identifying potential wealth creators and backing them for years. This year has been quite volatile for equities and bulk of the returns have come in steep spurts spread over a few days. According to Annual Wealth Creation Study, a study on wealth creating companies, conducted by Motilal Oswal Securities Ltd, investing in equity isn’t really about catching that spurt in stock prices, rather it is about identifying a company’s potential to create value and sticking to the choice in the long run.

The study shows ITC Ltd is the biggest wealth creator in the 2007-2012 with a market capitalization of 1.19 trillion. Whereas the most consistent wealth creator is Kotak Mahindra Bank Ltd whose stock price has given a compounded annual growth rate (CAGR) of 48% in the last 10 years in terms of absolute wealth creation. According to the study, wealth creation is defined as the difference in market capitalization over five years (2007-2012) after adjusting for equity dilution and the stock price should have outperformed the Sensex. What it shows is good quality businesses which have an intrinsic value greater than their market price, grow investors’ wealth in the long term. This underlines the basics of equity investing; don’t try to time markets and invest for the long term based on company fundamentals.

Wealth creators are unique

For a company to create wealth consistently, it has to offer a unique product or service. Says Raamdeo Agrawal, joint managing director, Motilal Oswal Securities Ltd, “Our first step to identify companies with competitive advantage or economic moat is looking at profits in the last 10 years. That should be above industry average. Sustainability of profits is important and so is the ability to make money going forward."

Asset managers take into consideration a concept called economic moat to outline the competitive advantage a company has. Having a competitive advantage enables a company to boost earnings and make money in the future. Moringstar Inc., a global independent equity research provider, in its annual investor conference held in Mumbai on 1-2 November also talked about the importance of this concept, which it said is the cornerstone of its investment philosophy. According to Moringstar, an economic moat is a structural competitive advantage that allows a firm to earn above average returns on capital over a period of time.

Whether one defines it on the basis of profit or return on capital, economic moat measures the potential a company has to successfully overtake competitors over the long run. A company which has a distinctive product or service backed by competent management has the potential of growing earnings consistently over a long period of time and this translates into profit for investors as earnings growth gets reflected in stock prices.

Wealth creators beat the market

The wealth creation study also shows the potential of such stocks to beat benchmark returns. In the last five years, the top 100 wealth creating companies in the study delivered an earnings CAGR of 21% compared with benchmark earnings CAGR of only 9%. Stocks prices for these companies have given a return of 20% CAGR in the period compared with 6% for the Sensex.

This clearly shows the merit in backing fundamentals over trying to time the market. Even if you look at year-to-date (YTD), among the Sensex stocks the companies whose earnings visibility is higher have significantly outperformed in terms of stock price rise. While the Sensex has given around 25% return YTD, eight companies have delivered returns over 40% for the same period. Among them, for example, is ITC which rose 52% after a 15% rise in 2011. However, this year the rally in ITC may have been a combination of fundamental and market factors. Says Alex Mathew, head research, Geojit BNP Paribas Financials Ltd, “Fundamentals are the most important; one has to analyse management credibility and capability, quality of the product, financial health and competitors’ position and then decide on whether to buy a stock. At the same time, when markets are not doing well, choice of high dividend paying companies and those with healthy cash balance helps." Hence, there is an element of market environment which needs to be considered.

Identify your best option

Not everyone has the time and inclination to analyse stocks and be able to identify potential wealth creators. If that’s the case for you as well, don’t fret. Identify above average funds, those that outperform the benchmark consistently over a period of 5-10 years and put money in them. The strategy remains the same—identifying wealth creators.

Mint50 list of recommended funds screens historical performance to come up with schemes across categories. You can choose funds for equity allocation from the list.

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